SEOUL, April 29 - South Korea suspects the North sank one of its navy ships last month in an attack that killed 46 sailors.
The following is a look at how the military dynamics on the troubled peninsula could change by what may be one of the deadliest strikes since the end of the 1950-53 Korean War and the likely reaction by financial markets.
Market players do not see the South as planning a revenge strike on the North, but do expect it to increase its military presence near the sea border where its ship went down. They worry that Seoul could then be more likely to attack North Korean vessels nearing the border, instead of issuing warnings first, as it has done before, leading to firefights that spook markets.
When news first broke of a possible North Korean link shortly after the Cheonan sank in late March, shares on Wall Street fell, the won dropped and the price to insure South Korean sovereign debt rose to 83 basis points from 78 basis, increasing the cost to insure $10 million in debt by $5,000 to $83,000.
The South’s main military ally in the United States and the North’s biggest backer in China both see it in regional and global interests to prevent an escalating conflict and will pressure Seoul and Pyongyang to keep their tempers and armies under control. The two global powers may not be able to prevent brief, live-fire exchanges between the rival Koreas who station more than 1 million troops near their border.
But North Korea may still resort to saber-rattling that often includes short-range missile tests and threats to attack its capitalist neighbor as it tries to win concessions from global powers to decrease the threat it poses to the economically vibrant region. Markets are long used to this and do not expect such moves to have any impact on trading.
A step seen as a larger provocation would come from Pyongyang test-firing its ballistic missiles that are designed to hit all of the South, most of Japan and U.S. military bases in Guam.
They have already been deployed and the North is trying to improve their range and accuracy. If the North demonstrates improved missile technology, it increases the long-term risks to the region, and market jitters might ripple beyond South Korea to affect sentiment on Japanese stocks and the yen.
But unless markets thought there was a chance leader Kim Jong-il was moving closer to firing these missiles in anger, any sell-off would be modest and quickly reversed.
North Korea has tested nuclear devices twice. A third test would put it closer to having a working nuclear bomb, but it would also deplete its meager supply of fissile material, which is thought to be enough for six to eight bombs.
Because a third nuclear test would not significantly alter market perceptions of risks, any negative impact on asset prices would again be relatively small and short-term.
Experts say even if North Korea develops a bomb, it has no practical means to deliver it because its Soviet-era bombers would be no match for U.S., Japanese and South Korean air forces in the region. They add the North is several years away from developing the technology needed to miniaturize a nuclear weapon to mount on a missile and question whether it will ever be able to master the difficult process. So for the moment this is not a scenario that much worries markets.
Editing by Jonathan Thatcher and Sanjeev Miglani